RECORD ROYALTIES:
PHYSICAL SALES VERSUS DIGITAL DOWNLOADS

The system used by record companies to calculate royalties has never been entirely fair to the artist. With the advent of the World Wide Web and downloadable music, now it simply doesn't make any sense!

Record royalties are typically based on the suggested retail price of a record less several deductions. These deductions include packaging costs, free goods, breakage, new technologies, and foreign (to name a few). When a consumer purchases a CD from a retail store at around $18.98, a new artist with a royalty rate of approximately 16 percent is usually credited a royalty of around $1.00 per sale-for sales of singles, it's far less. When a consumer logs on to a web site such as Amazon.com and downloads the contents of a CD directly to their computer, is it reasonable for record companies to apply the same royalty calculation that is applied to a physical product? Most agree, the answer is no.

Package Costs

Record companies typically deduct up to 25 percent off of the suggested retail price from sales of your record to theoretically cover the expenses for the plastic cases and artwork in which your record is sold. However, the amount the record company deducts, approximately $4.94 per CD (i.e., 25% x $18.99), is much more than the actual cost of packaging your record. In reality, it costs the record company around 70 cents to package each record. To make matters worse, in the world of digital downloading there is obviously no packaging included in a digital transaction, yet record labels still use packaging deductions today to compute artists royalties.

Free Goods

A royalty deduction for free goods also makes no sense in the world of digital downloads. Free goods are a so-called purchasing incentive that is offered to retailers in order to encourage sales. The royalty deduction is typically 15 percent. For every 100 records shipped, the record company theoretically invoices retailers for only 85 records. The 15 free records are non-royalty bearing records; therefore the artist is not paid for them. In the case of music sold via digital download, a royalty deduction for free goods is meaningless. No records are sold or shipped to retailers. In fact, the record company's profit margin significantly increases because they don't incur any manufacturing, distribution or freight costs. Yet, The artist does not get one dime more!

Breakage

Moving right along, deductions for breakage are especially ridiculous when calculating royalties in a digital world. Breakage deduction dates back to the days when 78's were commonly in production. 78s were manufactured from shellac and were susceptible to damage during shipping. Even though CDs and cassettes replaced 78s long ago, some record companies still insist on breakage deductions of approximately 10 percent. For every 100 records sold, the artist receives a royalty for only 90 percent. Subtract an additional 15 percent for free goods and the artist is now paid for only 76.5 percent of all records sold. Can this deduction justifiably apply to the calculation of digital sales? Don't answer that.

New Technologies

Another deduction to consider is CD reduction. Record companies typically take a deduction for new technologies like CDs since manufacturing costs are high in the beginning. Despite the fact that CDs are not particularly new anymore and manufacturing costs have leveled out, record companies still get away with using this deduction-and yes-it currently applies to digital downloads as well! CD reduction is usually 85 percent of the royalty rate for cassettes. Chances are the deduction for digital downloads will even increase to 85 percent of the rate for CDs? Only time will tell.

Foreign

Deductions for foreign royalties is another point to consider in the issue of physical sales versus digital downloads. Artists typically receive a record royalty that is 75 percent of their U.S. basic rate for major markets such as Japan, the United Kingdom, Germany, Holland, France and Italy. For other territories in the world the royalty is 50 to 60 percent of the U.S. basic rate. But how can territories be defined over the Internet for both physical and digital sales when the World Wide Web is a global market? This is a very serious issue that may take years to resolve.

So where is all of this mess concerning royalties going to end up? Entertainment attorney Donald Passman has an interesting theory called "The Passman Theory of Technology Cycles." It paraphrase, it goes something like this: Every time a new technology is discovered, it sends the record industry into a frenzy. Right now downloadable music is still a new technology and the record companies don't know its economics. Despite the fact that digital sales may seem more profitable, there are huge costs for setting up download capability. This results in a royalty structure that is not particularly fair to the artist. Eventually a reasonable system for computing digital downloads will be devised and an industry pattern will form. By then, the next technological advancement will be discovered and the cycle will begin all over again.